By now you probably know that defined benefit plans are one of the best available retirement structures. Unfortunately, most people don’t know the defined benefit plan rules and requirements or how to structure the plans for maximum benefit.
Accumulating $1 million in retirement is tough. So, before we dive into the strategies, let’s take a look at some of the basics. This is critical to understanding how a plan can work for your business.
Table of contents
What is a defined benefit plan?
Define benefit plans are retirement accounts that promise a predefined retirement income to their plan participants. The monthly payouts depend on several factors, such as age, employment history, and income level of the plan participant.
It is important to note that the payment method might vary from one company to another. Some organizations follow a conventional annuity structure, where their employees receive monthly benefits. Others might offer lump sum payment at the time of retirement of the employee.
You can think of it as a 401k on steroids. It will offer substantially higher contributions, sometime double or triple the amount depending on age and income.
However, they are more expensive and are administratively more complex. But if you are looking for large tax deductible contributions this might be your best bet.
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o why should you consider a defined benefit plan? Simply put – no other retirement plan structure allows business owners to get as much money into a plan and still get a tax deduction.
You can’t get this with an IRA, 401k or a SEP. While there can be some disadvantages, they are the best retirement vehicle for high-income business owners.
How do defined benefit plan rules differ from defined contribution plans?
One of the common confusions among plan participants is about the difference between defined benefit plans and defined contribution plans. Unlike defined benefit plans, employers have no obligations to assume investment risks under defined contribution plans.
In defined contribution plans, employees are responsible for both contributing as well as tracking their investments, although most of the employers offer a small matching contribution, up to 3% of annual salary, to these plans.
401k plans are the most common type of defined contribution plans available in the private sector.
Defined benefit plan rules and requirements
Defined benefit plans are one of the faster growing retirement structures. This is a result of high contribution levels and significant tax deductions.
Most of the requirements revolve around eligibility and funding levels. For example, take a look at the following three rules:
- Include less than half your employees – There is no requirement that you have to cover all your employees. In fact, IRS only requires a 40% coverage. IRS section 401(a)(26) stipulates 2-part tests as follows:
- Employees receiving a benefit under a plan should be a lesser of 50 people or 40%; and,
- “Meaningful” contributions to be made towards the plan.
Those are a few of the basic plan rules that must be followed. Once we have determined employees and eligibility, we can take a closer look at the calculation.
The good news is that the deadline has been extended. You now have up to the date your tax return is filed (including extensions) to set up and fund a plan. But don’t cut it too close. You will need a few weeks to get the plan established and the account opened and funded. So make sure you do it timely.
Understanding minimum benefit rules
One of the IRS requirements for a valid plan is the “meaningful benefit” to the participant. IRS defines this as an accrued benefit of at least ½% of pay.
While IRS does not specify ½% defined benefit credit itself, it should be large enough to generate a ½% retirement benefit. This will translate to about 2-3% of the current pay depending on employee salary and age. For example, an employee with a $40,000 annual salary has a benefit of about $800 to $1,200.
Age-weighted contributions mean that older employees have larger contribution while younger employees contribute less. The plan cannot benefit small groups of employees. This can invalidate the plan.
Due to defined benefit plan age-weighted capacity, a business owner can eliminate some older employees and include some young ones. This can result in a lower overall employee contribution while still being a meaningful benefit.
Who is eligible for a defined benefit plan?
Who is eligible? You can typically exclude employees who are under age 21 and who work less than 1,000 hours in a year. Make sure that you coordinate with your accountant and administrator.
An actuary will determine annual contributions based on several factors, including:
- retirement age;
- employee’s life expectancy;
- annual retirement benefit amount;
- interest rates; and
- potential employee turnover.
Once the employee attributes are identified, the company has the option of selecting a formula. For example, any of the following formulas may be used:
- flat dollar amount or unit benefit;
- percentage unit benefit; and
- flat percentage of pay.
A flat dollar amount uses a flat annual amount, for example $1,500. Benefits can be calculated as a flat percentage of pay or an average of salary.
For example, an employee that worked for 25 years will receive 50% of his or her average earnings (on an annual basis) during the three consecutive years of employment with the highest earnings.
A flat amount unit formula uses a flat amount with each unit of service, normally with each year. For example, an employee with 50 units of service would receive a benefit equal to 50 times the unit amount at retirement.
The most popular defined benefit formula is the percentage unit benefit. It considers both the level of compensation and years of employee service. If you want to run your numbers take a look at our plan calculator.
What is a third-party administrator (TPA)?
There are many different rules applicable to defined benefit plans. But the most significant rules relate to non-discrimination (including eligible employees), annual contribution limits, and sign off by an actuary. For these reasons, make sure you have an administrator (TPA) that understands the complexity of these plans including the limitations.
Let’s dig a little deeper into what TPAs do for defined benefit plans. TPAs will for example:
- Provide consultation regarding the design of the plan, taking into account the financial goals of the employer as well as employees;
- Create a blueprint example for the operational activities throughout the plan;
- Draft plan documents;
- Work with an actuary for compliance and risk assessment;
- Design contribution and distribution policies of the plan suiting you as well as critical employees;
- Ensure that the plan complies with the rulings mentioned under ERISA;
- Provide tax filing services (5500).
Need for specialization
Some employers might require specific services for their retirement plans. For instance, a cash balance plan involves accurate, timely compliance filings, requiring particular legal skills. A potential candidate should know his/her way around your specific requirements.
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Start by providing critical information to the TPA, such as the size of your business, number of employees, age of employers and key employees, and financial goals associated with the plan.
After sharing these details, find out whether the TPA:
- Understands the administration responsibilities required by the Department of Labor (DOL) and IRS, such as plan design or customizations, installation of the plan, drafting requirements, enrollment procedure, compliance testing, required government reporting, and the need for actuarial services, etc.
- Can handle plan administration along with additional services such as financial advisory or payroll management. Ideally, choosing a TPA that offers specialized services for specific types of defined benefit plans is a better choice in most cases.
Final thoughts
These plans can be challenging to understand. Hopefully, you have learned a little about how these plans are structured and know more about the defined benefit plan rules.
So what is a defined benefit plan? If you’re guilty of running short on your retirement savings goal, a defined benefits plan is an excellent option to start with. We’ve created this comprehensive guide to help you get a head start in your retirement preparations.
So there you have it. We have covered the rules and tried to make them as simple as possible. If you still have questions, please give us a call and we can answer any remaining questions you may have.
